Tuesday, July 31, 2007

Die Wanna Wanga

Get it?

Anyway, Thomson is reporting that Citigroup et. al are considering pulling out of financing the TXU LBO. If that happened, it would certainly change everything. Here is the math as to why this works, in theory. Bear in mind, I think this is incredibly unlikely, more on that later.

Let's say you bought $37 billion of a 10-year bond rated Ba2. Let's say that the high-yield market falls apart and the bond widens by 150bps. That bond probably declines in value by around 12%, or around $4.4 billion in losses.

Now let's say you retain an option to simply walk away from the bond and get all your money back by paying a $1 billion penalty. Sounds like a no-brainer right?

TXU's financiers face a similar problem. They made a bridge loan at a time when junk spreads were at all-time tights, and now that the market has moved markedly wider, that loan ain't looking so hot. Not only are they going to get hung with carrying the debt much longer than they wanted to, but they also stuck with a spread that really isn't adequate given today's market.

But LBO's usually have an out clause, by which either party can walk away by paying a large fee to the other party. If the banks were willing to pony up the break up fee, maybe they could get out of these loans.

Bank's may not really be marking-to-market loans in the same manner you might a portfolio of public bonds, but the economics aren't ultimately much different. If the bank could make new loans with 150bps more in spread today but their capital is tied up in the TXU bridge, that is a real economic problem. So it isn't just about paper losses. I believe if they really could get out of some of the financing deals by just paying the breakup fee, with no other repercussions, they would do it.

However, the world isn't that simple, is it? First of all, I believe KKR and TPG would have to agree to break up the deal. I don't believe (someone can correct me if they know better) that the banks have the right to force a breakup. Why would KKR and TPG agree to this? They still have too much cash, and now that the junk market is less hospitable, future deals are going to be tougher to come by. Why walk away from a deal where they've already secured cheap financing? $1 billion just wouldn't be enough to entice them.

Second, banks still want to make loans, they just want to do it at more favorable terms. But basically reneging on one of these LBO deals would cause potential future borrowers to stay away. The damage to reputation would be enormous.

Third, TXU is a relatively good credit to lend to. It's a utility with large real estate and other hard assets to its name. If banks are going to renege on a LBO deal, I'd think First Data or Alltel or Clear Channel would be better choices. None has assets as attractive as TXU. This morning I heard FDC CDS was 70bps tighter, for what that's worth. Didn't hear whether that followed through or not.

One popular theory is that the tumult in the credit market will lead to PE firms negotiating lower prices on the LBOs. Maybe. Particularly if the threat of banks pulling out becomes more credible. The PE firm may go back to someone like FDC and say look, we can't finance this thing any more at the same levels. Accept a lower price, or we're out. The target firm may be the one to blink and accept a lower price. Or a strategic buyer may emerge as an alternative.

So I doubt this is much more than Citi trying to negotiate better terms in light of changing market conditions. But it's a story that bears watching.

9 comments:

Anonymous said...

But basically reneging on one of these LBO deals would cause potential future lenders to stay away.

Lenders - should it be borrowers?

Anonymous said...

I am extraordinarily impressed that the yen is going up and the market is going down...in the face of excellent consumer confidence numbers. And apparently excellent employment.

Forgive me for not knowing which is the tail and which is the dog.

Forgive me also for beginning to wonder if the markets are all about leverage and mark to model. That, in other words, there's no there there.

Why is the market down today?

TDDG said...

Anon #1:

Yes. I'm an idiot.

Anon #2

Market is down on a story that American Home Mortgage is having liquidity problems. See here...

http://calculatedrisk.blogspot.com/2007/07/american-home-mortgage-provides-update.html

Anonymous said...

The acquired would likely not walk, so then its KKR and they would need to pay the fee. KKR may see its numbers changing too so they may have incentive to walk. Depends. KKR were recently talking tough "caveat lender" so now its bankers turn. These need each other. If they both get muddy they'll just join the 2007 mud club.

Anonymous said...

Die Wanna Wanga?

Isn't that a Return of the Jedi reference?

Anonymous said...

Sorry, I always leave stuff out.

Yes, I know the American Home Mortgage story. But, for the love of Mike, it's a nothing burger in a trillion dollar economy with booming employment, rising incomes, and ebullient consumer confidence.

Isn't it?

Serious question.

Anonymous said...

More than anyone knows, hedge funds have been borrowing yen and pouring it straight into highly speculative equities the world over. If you asked me to name two asset classes that have just ridiculous yen carry, based on tight correlations, I would say U.S. small cap stocks and Taiwan stocks. The hedge funds that do this operate 24/7, and they are constantly watching both their yen exposure and their equity exposure, adjusting both in synch.

Basically, they've minted money with this trade over the past 9 months, while constantly ramping up leverage. Whenever speculative markets rise, they borrow more yen and invest more. One reason U.S. stock future appreciate in the wee a.m. is because that's been when yen is least vulnerable.

Now, two things are changing: 1) hedge funds that are losing money in debt derivatives are unwinding yen carry to fulfill obligations; and 2) traders on the other side smell blood and are engineering a yen short squeeze. No, the yen is not too big to squeeze the shorts. It's happening.

As it continues, the most speculative equities will just fall apart. Watch Taiwan and the Russell 2000 in the weeks ahead. Better yet, short them.

anonymous3 said...

"it's a nothing burger in a trillion dollar economy with booming employment, rising incomes, and ebullient consumer confidence."

You might consider turning off CNBC and start reading the fine print...

TDDG said...

Here's what notable about AHM causing the market to tank yesterday. Say you surveyed the top 1000 money managers, hedge fund traders, NYSE floor traders, etc. Asked them what the odds were that additional mortgage originators would wind up going bankrupt? Beyond the ones currently bankrupt or very close. What would the average response have been? 90%? 95%? I mean, I would have answered 100%.

So then it actually happens, and everyone acts surprised? It just shows that fear is gripping the market, and people just don't want to own risk assets.